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Cost Benefit Analysis Toolkit v2
Cost Benefit Analysis Toolkit v2
One of the key items in any business case is an analysis of the costs of a project that includes some
consideration of both the cost and the payback (be it in monetary or other terms).
1. A basic analysis
1.1 Benefit measures:
For Small projects a cost-benefit analysis can be fairly basic the table below gives an example of
what might be appropriate.
Benefit of proposed
product(s)
Evidence
Return on investment
Financial analysis of the cash flows associated with the new technology, to
show a net gain. Simple payback techniques are OK for Small projects
(section 3.1).
Improved performance
e.g. lower operating
costs; improved
quality; better
customer service;
higher speed or more
flexibility
Better customer
service
suppliers;
results of pilots;
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Item1
External
consultant
12,500.00
15,000.00
New staff
requirement4
35,000.00
42,000.00
47,500.00
57,000.00
Item 1 purchase
Net expenditure
()
Gross
expenditure2 ()
10,000.00
12,000.00
1,250.00
1,500.00
Item 1 annual
maintenance3
1,750.00
2,100.00
900.00
1080.00
Totals
13,900.00
16,680.00
Grand total
73,680.00 (gross)
Training
Installation
Consist of:
Income
Number of Admissions,
Research Grants
Production Cost
Courses,
Consumable facilities,
Media
Labour Cost
(could split into
academic / non-
Wages,
Hours,
Output
Options:
Always state rate at which VAT is calculated in this example its 20%
Always include recurring cost items and make it clear what the recurring cycle is, e.g. monthly, annually.
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academic)
Capital Costs
Land,
Facilities,
Construction
Reduce wages!
Eliminate waste/improve work flow
Improve attendance
Reduce square footage requirements
Buy cheaper real estate
Reduce equipment/build out costs
Reduce construction timeframes
Secondary
Internal:
Internal:
costing information;
employee feedback;
internal reports;
pilots/simulations.
External:
External:
customer views;
expert opinion.
word of mouth/networks.
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1000
600
400
4
5
6
(600)
Zero
400
It is simple! Research has shown that UK firms favour it. This is understandable given how
easy it is to calculate.
In an environment of rapid technological change, systems may need to be replaced sooner
than in the past, so a quick payback on investment is essential.
Payback summary
It is best used as an initial screening tool, but it is inappropriate as a basis for sophisticated
investment decisions. In MMU it is OK for projects with budgets of up to 1 million. Projects with
greater costs should employ a more sophisticated analysis based on net present value (NPV) or
internal rate of return (IRR), as explained below.
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Now 1 year
2 years
3 years
from now from now from now
--- n
n years
from now
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The present value for 0 years is always 1, and this is not included in the present value table.
If you are looking to find the present value of 150,000 which you expect to receive in 5 years time,
at a rate of interest of 3%, the following steps are taken:
Step 1 Use a NVP lookup table (see separate spreadsheet: net_pres_value.xlsx) and find the
relevant number of years (5 years in this example).
Step 2 Look across the row for relevant the rate of interest (3% in this example).
Step 3 Take the value you have found from steps 1 and 2 (in this case this is 0.863 and
multiply the present amount (150,000) = 129,450.
NPV Illustration
On its own, this doesnt tell us much, so youd then use this against your projected cash flows or
savings/profits, e.g.
Year Cash Flow ()
3% Discount Rate
Present Value ()
(150,000)
1.000
(150,000)
12,000
0.971
11,652
25,000
0.943
23,575
25,000
0.915
22,875
35,000
0.888
31,080
40,000
0.863
34,520
26,298
A positive NPV means that the project is worthwhile because the cost of tying up capital is
compensated for by the cash inflows that result. When more than one project is being appraised,
you choose the one that produces the highest NPV.
3.4 Internal Rate of Return (IRR):
Sometimes we will want to know how well a project will perform under a range of interest rate
scenarios. The aim with IRR is to answer the question: What level of interest will this project be able
to withstand? Once we know this, the risk of changing interest rate conditions can effectively be
minimised (especially in the current climate!).
The IRR is the annual percentage return achieved by a project, at which the sum of the discounted
cash inflows over the life of the project is equal to the sum of the capital invested.
Another way of looking at this is that the IRR is the rate of interest that reduces the NPV to zero.
Imagine a scenario where we are considering whether to accept or reject an investment project, on
the basis of their acquiring the funds necessary at a known rate of interest.
The NPV approach asks if the present value of cash inflows less the initial investment is
positive, at the current borrowing rate.
The IRR approach asks if the IRR on the project is greater than the borrowing rate.
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Now, using IRR, we assume the 3% discount rate might well increase in the future so heres the same
project using a 5% rate:
Year
Cash Flow ()
5% Discount Rate
Present Value
()
-150,000
1.000
-150,000
12,000
0.952
11,429
25,000
0.907
22,676
25,000
0.864
21,596
35,000
0.823
28,795
40,000
0.784
31,341
-34,164
The negative result shows that 5% will be too high a rate, and the IIR will be somewhere between 3%
and 5%.
IRR = 3% + Difference between the two discount rates * Positive NPV
Range of +/ve to -/ve NPVs
IRR = 3% + (2% * 26298)
60462
IRR = 3.87%
IRR Summary
The value to a business of calculating the IRR is that its decision-makers are able to see the level of
interest that a project can withstand. In the case where a number of projects are competing for
selection, the one that is most resilient can be chosen.
IRR should not be used to compare mutually exclusive projects, however. For example a project with
a lower IRR may in fact have a higher NPV so the potential income (or saving) could be higher.
Also IRR should not be used to compare project of different durations because it doesnt consider
cost of capital (expected return on capital).
Another problem with IRR appears with projects that have irregular cash flows alternating between
positive and negative values several times. Numerous IRRs can be identified for such projects
potentially leading to confusion and the wrong investment decisions being made.
3.5 Modified Internal Rate of Return (MIRR)
This is usually used to rank various choices. As the name implies, MIRR is a modification of the
Internal Rate of Return (IRR). MIRR adds up the negative cash flows after discounting them to time
zero, adds up the positive cash flows after factoring in the proceeds of reinvestment at the final time
period, then works out what rate of return would equate the discounted negative cash flows at time
zero to the future value of the positive cash flows at the final time period. This rate of return is the
MIRR.
Luckily there is an Excel formula to calculate MIRR which takes three arguments: the range of values
of payments / income over the period of the project, the interest rate, and the reinvestment interest
rate. Heres a worked example using the 150,000 project and the same cash flow as in the above
example:
MMU Cost Benefit Analysis toolkit (v2)
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Data
-150,000
12,000
25,000
25,000
35,000
40,000
3.0%
2.0%
5.0%
-1.2%
-0.3%
Description
Initial cost
Return first year
Return second year
Return third year
Return fourth year
Return fifth year
Annual interest rate for the 150,000 loan
Annual interest rate for the reinvested profits (likely scenario)
Annual interest rate for the reinvested profits (hopeful scenario)
Investment's MIRR after five years (likely)
Investment's MIRR after five years (hopeful)
In Excel, heres what you would enter for the data column:
A
1
2
3
4
5
6
7
8
9
10
11
12
Data
-150000
12000
25000
25000
35000
40000
3.0%
2.0%
5.0%
=MIRR(A2:A7, A8,A9)
=MIRR(A2:A7, A8, A10)
You can, of course, do what-if scenarios by varying the percentage amounts in cells A8, A9 and
A10, or by giving different values for the return for each year. According to our current example, this
would be quite a risky project in terms of cash return (though of course there may be other reasons
why we want to do it).
Bruce Levitan
Business Improvement Manager
October 2010 (v2)
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